In the last two years, the total transfer values paid from defined benefit (DB) pension schemes that JLT administer has increased by 217%. Nearly all of these transfers out were made to defined contribution (DC) schemes.
DB transfers-out: 2016 vs. 2014
This is not a phenomenon that is unique to JLT. Other third party pension scheme administrators have reported similar experiences. In this Let’s Talk, we consider the reasons for this experience and the issues raised by it.
WHY THE SUDDEN INCREASE IN INTEREST?
There are two principal reasons for this increased interest in DB to DC transfers:
- The ‘freedom & choice’ reforms introduced in April 2015 for DC schemes mean that, in addition to DC schemes being very flexible in terms of retirement options, they are also more attractive for paying down debt and benefits on death could be higher.
- Transfer values currently appear very generous, mainly due to the historically low level of gilt yields.
To illustrate the latter point, Chart A below considers how the transfer value of a deferred pensioner in a DB scheme might have changed over the last year. See the text below Chart A for summary details of the notional deferred pensioner member, his benefits and the calculation basis employed.
This member’s transfer value was fairly static over the year ending in May 2016 but has increased significantly since then – over the last 9 months it has been around 30% to 40% higher than it was a year ago (1 May 2016). (For a 40 year old member, this range would be approximately 40% to 60%, due mainly to the effects of compound interest over a longer term of deferral to normal retirement age).
The first significant month-on-month increase in the transfer value (+14.5%) was in July 2016 due to the impact of the EU referendum result on gilt yields at the end of June.
This was followed by a further significant increase between August and September 2016 due to the impact of:
- the reduction of the Bank of England base rate from 0.50% to 0.25%, and
- the related extension of the Quantitative Easing (QE) programme.
These led to a fall in gilt yields and an increase in market expectations of future price inflation. This ‘double-whammy’ increased this member’s transfer value by 15.8% between August and September 2016.
If we assume that this member takes the transfer value currently available, invests it until age 65 and then draws an income from it, we can estimate how that income might compare with the DB pension given up. Chart B below illustrates one such comparison for our notional member.
As Chart B illustrates, it may be possible to take a transfer and draw down a higher, sustainable income than might otherwise have been expected under the DB scheme. There are clearly risks involved with draw down – investment risk and longevity, for starters. There are also differences in death benefits to consider, but the position on draw down could be beneficial in terms of both the level of death benefit and tax.
Other reasons as to why a member may choose to give up the guarantees associated with a DB pension include:
- ill health, where a DB to DC transfer can result in higher benefits;
- they are single and/or do not need the dependant’s pension provided by their DB scheme.
CONSIDERATIONS FOR MEMBERS
Of course, a DB to DC transfer will not always be in a member’s best interests and the level of the transfer value for a set amount of DB pension will vary from scheme to scheme.
Strict rules apply where benefits are valued at more than £30,000. Once this threshold is reached, a member is not allowed to transfer without first taking independent financial advice. Some pension providers will not accept any DB transfer without prior advice, regardless of the value of the member’s benefits.
Advice on transferring from DB to DC will also help the member make an informed decision on what they would be giving up and what they might expect in return.
Other issues for members to think about include:
- Whether the trustees of the transferring DB scheme have decided to reduce transfers due to underfunding and whether there are any plans to review this decision
- Whether the member has any HMRC ‘protections’ against the Lifetime Allowance that could be affected by a transfer-out
- Not falling victim to a ‘pensions scam’.
RAISING AWARENESS (OR NOT)
Whilst interest in DB to DC transfers has undoubtedly increased, that is not to say that every member of a DB scheme knows about their rights to a transfer or how much their benefits could be worth. Consequently, a topical discussion amongst trustees of DB schemes and their advisers is whether transfer values should be routinely included on statements to members.
Trustees do not have to provide transfer values unless asked. However, given everything that has already been said in this Let’s Talk about why a member might want to transfer and bearing in mind that transfer values can change on a daily basis, more and more trustees are concluding that their members should be in a position to make informed decisions.
Our view is that the value of DB pensions and the option to extend ‘decumulation’ options by transferring to a DC arrangement are too important to be left to chance and all members should have this information, not just those who ask for it.
THE BEST OF BOTH WORLDS?
Another hot topic is whether schemes should allow their members to transfer out some but not all of their benefits under a DB scheme.
To be clear, we are not talking here about a member, with DB and DC under the same scheme, choosing to transfer one type of benefit whilst leaving the other behind. They can already do this as of right. The issue is whether a member should be allowed to transfer just part of his or her DB benefits, leaving the residual DB benefits behind. There is no legal right to this but schemes could allow it if they wished, assuming the necessary systems and procedures are in place.
Why would they want to? Well, there are at least two reasons why –
- Some members, who wish to free up more cash may currently be able to do so only by taking their whole DB pension as a transfer value. In transferring the whole benefit, members will be giving up significant guarantees including a known annual benefit for life, attaching dependants’ benefits and increases on the pension. They will also be replacing the employer ‘covenant’ with a provider covenant. So, it may not be in their best interests to take their whole benefit under a scheme as a transfer value.
- From a scheme perspective, extending the transfer options available to members, by introducing a partial transfer facility, could help reduce scheme liabilities.
It is also relevant to note that the Government has recently published a ‘Green Paper’ on DB pension schemes. Part of the proposals are initiatives aimed at addressing deficits in DB schemes (currently, the deficit, on a buy out basis, for all DB schemes is circa £900 billion). It is quite conceivable that one of the outcomes could be new transfer rights for members, including a statutory right to take partial transfer values.
THE EMPLOYER PERSPECTIVE
Employers are likely to welcome the opportunity to share with members the cash value of their accrued DB rights. If this motivates more members to transfer out (and remember, for most members, this is subject to prior independent financial advice) then there could be a positive impact on scheme liabilities.
On a similar note, in the current environment (see ‘Why the sudden increase in interest?’), there may currently be more traction (higher take up rates) with enhanced transfer value (ETV) exercises relative to pre-2015 or even pre-2016 ETV exercises. So, employers may want to build this into their DB pension scheme liability management plans even if they have undertaken such an exercise in the past.